Government Market Involvement, Exchange Rate Defense, at Limit

Analysis shows that the government’s defensive capabilities in the foreign exchange market may have reached their limit because the won-to-dollar rate has dropped and the value of the won declined for three consecutive days.

The government has interfered in this dispute while strongly denying this, but experts warn that there could be catastrophic chaos in the foreign exchange market with such a sudden drop in rate if the government maintains the high rate against the market flow.

The exchange rate has been steadily decreasing. The won-to-dollar rate in the Seoul Foreign Exchange Market on January 20, right before the lunar new year holiday, reached 1,188 won. But it fell to 1180.5 won on January 26, 1176.2 won on January 27, and 1171.6 on January 29: a decline of 16.4 won in three days.

The exchange rate on January 18 was the lowest in two months and fifteen days since the mark of 1171.3 won was reached on November 14.

“The government is restraining its involvement in the foreign exchange market in the fear that it will become an issue at the G7 finance ministers’ talks held in the United States on February 6 and 7,” said foreign exchange team manager Koo Kil-mo at the Korea Exchange Bank (KEB). “The current trend will lead the rate to the 1170 level in the longer run, but how long the current trend will keep its course depends on the government.”

The government reiterated its will to defend the exchange rate, making it seemingly aware of the market’s view on the phenomenon.

“We view the ‘proper rate’ as the level where mid-sized companies do not experience losses due to the rate,” said international finance department head Choi Joong-gyeong at the Finance and Economy Ministry. “If the rate drops further from the current level, most companies, except healthy corporations such as Samsung Electronics, will be in trouble.”

“We will unavoidably have to involve in the market if the investors in the market become too speculative,” said Vice Prime Minister and Finance and Economy Minister Kim Jin-pyo in support of Choi’s argument.

Is the limit really near? The analysis that the government has met its capacity limit in its foreign exchange rate defense, a devise to boost exports which accelerated the Korean economic development, is gaining more supporters.

The limit of the Foreign Currency Equilibrium Fund Bond, which is intended to stabilize the foreign exchange market and is issued by the Finance and Economy Ministry, now only has 5.8 trillion won left. The currency stabilization securities that the Bank of Korea issues to absorb the money released out with the Equilibrium Bond have reached 10.5 billion won, meaning that the interest involved would exceed 5 trillion won yearly.

Additionally, the Korean stock market experienced more than 4 trillion won of foreign investment this month, and export results are still in the black. The United States and EU nations will almost certainly mention the problem of the exchange rate defenses of Japan and Korea at the G7 talks next month.

“The government should be involved at a level that does not go against the international market flow where the dollar is becoming weak at the current point,” said researcher Kang Sam-mo of the Korea Finance Institute. “If it defends too excessively and gives it up when it finally hits the limit, the foreign exchange market will be in chaos and export companies will experience drastic losses due to the exchange rate.”

Joong-Hyun Park Ki-Jeong Ko sanjuck@donga.com koh@donga.com